Ch05 Uncertainity and Consumer Behaviour

CHAPTER
5
Uncertainty and Consumer Behavior
Prepared by: Fernando & Yvonn Quijano
2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.
CHAPTER 5 OUTLINE 5.1 Describing Risk

5.2 Preferences Toward Risk
Chapter 5 Uncertainty and Consumer Behavior
5.3 Reducing Risk 5.4 The Demand for Risky Assets 5.5 Behavioral Economics
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Uncertainty and Consumer Behavior

Sometimes we must choose how much risk to bear. 1. In order to compare the riskiness of alternative choices, we need to quantify risk.
2. We will examine peoples preferences toward risk. 3. We will see how people can sometimes reduce or eliminate risk. 4. In some situations, people must choose the amount of risk they wish to bear. In the final section of this chapter, we offer an overview of the flourishing field of behavioral economics.
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5.1
DESCRIBING RISK
Probability
probability Likelihood that a given outcome will occur.
Subjective probability is the perception that an outcome will occur.

Expected Value
expected value Probability-weighted average of the payoffs associated with all possible outcomes. payoff Value associated with a possible outcome.
The expected value measures the central tendencythe payoff or value that we would expect on average. Expected value = Pr(success)($40/share) + Pr(failure)($20/share) = (1/4)($40/share) + (3/4)($20/share) = $25/share E(X) = Pr1X1 + Pr2X2 E(X) = Pr1X1 + Pr2X2 + . . . + PrnXn
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5.1
DESCRIBING RISK
Variability
variability differ.
Extent to which possible outcomes of an uncertain event
TABLE 5.1
Income from Sales Jobs

OUTCOME 1
Probability Income ($)
OUTCOME 2
Probability
Expected Income ($) Income ($)
Job 1: Commission Job 2: Fixed Salary
.5
.99
2000
1510
.5
.01
1000
510
1500
1500
deviation
TABLE 5.2
Job 1 Job 2
Difference between expected payoff and actual payoff.

Deviations from Expected Income ($)
Outcome 1 2000 1510 Deviation 500 10 Outcome 2 1000 510 Deviation -500 -990
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5.1
DESCRIBING RISK
Variability
Table 5.3
Calculating Variance ($)

Weighted Average Deviation Deviation Squared Squared 250,000 980,100 250,000 9900
Outcome 1 Job 1 Job 2

Figure 5.1
Deviation Squared 250,000 100
Outcome 2 1000 510
Standard Deviation 500 99.5
2000 1510
Outcome Probabilities for Two Jobs
The distribution of payoffs associated with Job 1 has a greater spread and a greater standard deviation than the distribution of payoffs associated with Job 2. Both distributions are flat because all outcomes are equally likely. 2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.
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5.1
Figure 5.2
DESCRIBING RISK
Variability
Unequal Probability Outcomes
The distribution of payoffs associated with Job 1 has a greater spread and a greater standard deviation than the distribution of payoffs associated with Job 2.
Both distributions are peaked because the extreme payoffs are less likely than those near the middle of the distribution.
Decision Making
Table 5.4 Incomes from Sales JobsModified ($)
Deviation Squared 250,000 100 Deviation Squared 250,000 980,100 Expected Income 1600 1500 Standard Deviation 500 99.5
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Outcome 1 Job 1 Job 2 2000 1510
Outcome 2 1000 510
5.1
DESCRIBING RISK
Fines may be better than incarceration in deterring certain types of crimes, such as speeding, doubleparking, tax evasion, and air polluting.
Other things being equal, the greater the fine, the more a potential criminal will be discouraged from committing the crime. In practice, however, it is very costly to catch lawbreakers. Therefore, we save on administrative costs by imposing relatively high fines.
A policy that combines a high fine and a low probability of apprehension is likely to reduce enforcement costs.
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5.2
Figure 5.3
PREFERENCES TOWARD RISK
Risk Averse, Risk Loving, and Risk Neutral
In (a), a consumers marginal utility diminishes as income increases. The consumer is risk averse because she would prefer a certain income of $20,000 (with a utility of 16) to a gamble with a .5 probability of $10,000 and a .5 probability of $30,000 (and expected utility of 14).
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5.2
Figure 5.3
Risk Averse, Risk Loving, and Risk Neutral
In (b), the consumer is risk loving: She would prefer the same gamble (with expected utility of 10.5) to the certain income (with a utility of 8).
Finally, the consumer in (c) is risk neutral, and indifferent between certain and uncertain events with the same expected income.
expected utility Sum of the utilities associated with all possible outcomes, weighted by the probability that each outcome will occur.
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5.2
Different Preferences Toward Risk

risk averse Condition of preferring a certain income to a risky income with the same expected value. risk neutral Condition of being indifferent between a certain income and an uncertain income with the same expected value.
risk loving Condition of preferring a risky income to a certain income with the same expected value.
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5.2
Different Preferences Toward Risk Risk Premium

risk premium Maximum amount of money that a risk-averse person will pay to avoid taking a risk.
Figure 5.4 Risk Premium
The risk premium, CF, measures the amount of income that an individual would give up to leave her indifferent between a risky choice and a certain one. Here, the risk premium is $4000 because a certain income of $16,000 (at point C) gives her the same expected utility (14) as the uncertain income (a .5 probability of being at point A and a .5 probability of being at point E) that has an expected value of $20,000.
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5.2
Different Preferences Toward Risk Risk Aversion and Income

The extent of an individuals risk aversion depends on the nature of the risk and on the persons income.
Other things being equal, risk-averse people prefer a smaller variability of outcomes. The greater the variability of income, the more the person would be willing to pay to avoid the risky situation.
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5.2
Different Preferences Toward Risk Risk Aversion and Indifference Curves

Figure 5.5 Risk Aversion and Indifference Curves
Part (a) applies to a person who is highly risk averse: An increase in this individuals standard deviation of income requires a large increase in expected income if he or she is to remain equally well off. Part (b) applies to a person who is only slightly risk averse: An increase in the standard deviation of income requires only a small increase in expected income if he or she is to remain equally well off. 2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.
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5.2
Are business executives more risk loving than most people?

In one study, 464 executives were asked to respond to a questionnaire describing risky situations that an individual might face as vice president of a hypothetical company.
The payoffs and probabilities were chosen so that each event had the same expected value. In increasing order of the risk involved, the four events were: 1. A lawsuit involving a patent violation 2. A customer threatening to buy from a competitor 3. A union dispute 4. A joint venture with a competitor
The study found that executives vary substantially in their preferences toward risk.
More importantly, executives typically made efforts to reduce or eliminate risk, usually by delaying decisions and collecting more information.
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5.3
REDUCING RISK
Diversification
diversification Practice of reducing risk by allocating resources to a variety of activities whose outcomes are not closely related. TABLE 5.5
Income from Sales of Appliances ($)
Hot Weather
Air conditioner sales Heater sales negatively correlated variables opposite directions. 30,000 12,000
Cold Weather
12,000
30,000
Variables having a tendency to move in
The Stock Market

mutual fund Organization that pools funds of individual investors to buy a large number of different stocks or other financial assets.
positively correlated variables the same direction. Variables having a tendency to move in
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5.3
REDUCING RISK
Insurance
TABLE 5.6
Insurance Chapter 5 Uncertainty and Consumer Behavior No Yes
The Decision to Insure ($)

Burglary (Pr = .1) 40,000 49,000 No Burglary (Pr = .9) 50,000 49,000 Expected Wealth 49,000 49,000 Standard Deviation 3000 0
The Law of Large Numbers

The ability to avoid risk by operating on a large scale is based on the law of large numbers, which tells us that although single events may be random and largely unpredictable, the average outcome of many similar events can be predicted.
Actuarial Fairness
actuarially fair Characterizing a situation in which an insurance premium is equal to the expected payout.
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5.3
REDUCING RISK
Suppose you are buying your first house. To close the sale, you will need a deed that gives you clear title. Without such a clear title, there is always a chance that the seller of the house is not its true owner. In situations such as this, it is clearly in the interest of the buyer to be sure that there is no risk of a lack of full ownership. The buyer does this by purchasing title insurance. Because the title insurance company is a specialist in such insurance and can collect the relevant information relatively easily, the cost of title insurance is often less than the expected value of the loss involved. In addition, because mortgage lenders are all concerned about such risks, they usually require new buyers to have title insurance before issuing a mortgage.
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5.3
REDUCING RISK
The Value of Information

value of complete information Difference between the expected value of a choice when there is complete information and the expected value when information is incomplete.
TABLE 5.7
Profits from Sales of Suits ($)

Sales of 50 Sales of 100 5000 12,000 Expected Profit 5000 6750
Buying 50 suits Buying 100 suits
5000 1500
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5.3
REDUCING RISK
Per-capita consumption of milk has declined over the yearsa situation that has stirred producers to look for new strategies to encourage milk consumption. One strategy would be to increase advertising expenditures and to continue advertising at a uniform rate throughout the year. A second strategy would be to invest in market research in order to obtain more information about the seasonal demand for milk. Research into milk demand shows that sales follow a seasonal pattern, with demand being greatest during the spring and lowest during the summer and early fall. In this case, the cost of obtaining seasonal information about milk demand is relatively low and the value of the information substantial. Applying these calculations to the New York metropolitan area, we discover that the value of informationthe value of the additional annual milk salesis about $4 million.
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5.3
REDUCING RISK
Suppose you were seriously ill and required major surgery. Assuming you wanted to get the best care possible, how would you go about choosing a surgeon and a hospital to provide that care? A truly informed decision would probably require more detailed information. This kind of information is likely to be difficult or impossible for most patients to obtain. More information is often, but not always, better. Whether more information is better depends on which effect dominates the ability of patients to make more informed choices versus the incentive for doctors to avoid very sick patients. More information often improves welfare because it allows people to reduce risk and to take actions that might reduce the effect of bad outcomes. However, information can cause people to change their behavior in undesirable ways.
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*5.4
Assets
THE DEMAND FOR RISKY ASSETS
asset Something that provides a flow of money or services to its owner.

An increase in the value of an asset is a capital gain; a decrease is a capital loss.
Risky and Riskless Assets

risky asset Asset that provides an uncertain flow of money or services to its owner.
riskless (or risk-free) asset Asset that provides a flow of money or services that is known with certainty.
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*5.4
Asset Returns
return Total monetary flow of an asset as a fraction of its price. Simple (or nominal) return on an asset, less the rate of real return inflation.
Expected versus Actual Returns

expected return Return that an asset should earn on average.
actual return
TABLE 5.8
Return that an asset earns.
InvestmentsRisk and Return (19262006*)

Average Rate of Return (%) Average Real Rate of Return (%)
9.2 3.1 0.7
Rate Risk (Standard Deviation, %)

20.1 8.5 3.1
Common stocks (S&P 500) Long-term corporate bonds U.S. Treasury bills
12.3 6.2 3.8
*Source: Stocks, Bonds, Bills, and Inflation: 2007 Yearbook, Morningstar, Inc.
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*5.4
The Trade-Off Between Risk and Return The Investment Portfolio

(5.1)
(5.2)
The Investors Choice Problem
(5.3)
Price of risk Extra risk that an investor must incur to enjoy a higher expected return.
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*5.4
The Investors Choice Problem Risk and Indifference Curves

Figure 5.6
Choosing Between Risk and Return
An investor is dividing her funds between two assetsTreasury bills, which are risk free, and stocks. The budget line describes the trade-off between the expected return and its riskiness, as measured by the standard deviation of the return. The slope of the budget line is (Rm Rf )/m, which is the price of risk. Three indifference curves are drawn, each showing combinations of risk and return that leave an investor equally satisfied. The curves are upward-sloping because a riskaverse investor will require a higher expected return if she is to bear a greater amount of risk. The utility-maximizing investment portfolio is at the point where indifference curve U2 is tangent to the budget line. 2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.
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*5.4

Figure 5.7
The Choices of Two Different Investors
Investor A is highly risk averse. Because his portfolio will consist mostly of the risk-free asset, his expected return RA will be only slightly greater than the risk-free return. His risk A, however, will be small. Investor B is less risk averse. She will invest a large fraction of her funds in stocks. Although the expected return on her portfolio RB will be larger, it will also be riskier.
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*5.4

Figure 5.8
Buying Stocks on Margin
Because Investor A is risk averse, his portfolio contains a mixture of stocks and risk-free Treasury bills. Investor B, however, has a very low degree of risk aversion. Her indifference curve, UB, is tangent to the budget line at a point where the expected return and standard deviation for her portfolio exceed those for the stock market overall. This implies that she would like to invest more than 100 percent of her wealth in the stock market. She does so by buying stocks on margini.e., by borrowing from a brokerage firm to help finance her investment. 2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.
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*5.4
Why have more people started investing in the stock market? One reason is the advent of online trading, which has made investing much easier.
Figure 5.9 Dividend Yield and P/E Ratio for S&P 500
The dividend yield for the S&P 500 (the annual dividend divided by the stock price) has fallen dramatically, while the price/earnings ratio (the stock price divided by the annual earnings-per-share) rose from 1980 to 2002 and then dropped.
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5.5
BEHAVIORAL ECONOMICS
Recall that the basic theory of consumer demand is based on three assumptions: (1) consumers have clear preferences for some goods over others;
(2) consumers face budget constraints; and (3) given their preferences, limited incomes, and the prices of different goods, consumers choose to buy combinations of goods that maximize their satisfaction or utility.
These assumptions, however, are not always realistic.

Perhaps our understanding of consumer demand (as well as the decisions of firms) would be improved if we incorporated more realistic and detailed assumptions regarding human behavior. This has been the objective of the newly flourishing field of behavioral economics.
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5.5
Some examples of consumer behavior that cannot be easily explained with the basic utility-maximizing assumptions:
There has just been a big snowstorm, so you stop at the hardware store to buy a snow shovel. You had expected to pay $20 for the shovelthe price that the store normally charges. However, you find that the store has suddenly raised the price to $40. Although you would expect a price increase because of the storm, you feel that a doubling of the price is unfair and that the store is trying to take advantage of you. Out of spite, you do not buy the shovel. Tired of being snowed in at home you decide to take a vacation in the country. On the way, you stop at a highway restaurant for lunch. Even though you are unlikely to return to that restaurant, you believe that it is fair and appropriate to leave a 15-percent tip in appreciation of the good service that you received. You buy this textbook from an Internet bookseller because the price is lower than the price at your local bookstore. However, you ignore the shipping cost when comparing prices.
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5.5
More Complex Preferences

reference point The point from which an individual makes a consumption decision.
endowment effect Tendency of individuals to value an item more when they own it than when they do not. loss aversion Tendency for individuals to prefer avoiding losses over acquiring gains.
Rules of Thumb and Biases in Decision Making

anchoring Tendency to rely heavily on one prior (suggested) pieces of information when making a decision.
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5.5
Probabilities and Uncertainty

An important part of decision making under uncertainty is the calculation of expected utility, which requires two pieces of information: a utility value for each outcome (from the utility function) and the probability of each outcome.
People are sometimes prone to a bias called the law of small numbers: They tend to overstate the probability that certain events will occur when faced with relatively little information from recent memory. Forming subjective probabilities is not always an easy task and people are generally prone to several biases in the process.
Summing Up
The basic theory that we learned up to now helps us to understand and evaluate the characteristics of consumer demand and to predict the impact on demand of changes in prices or incomes. The developing field of behavioral economics tries to explain and to elaborate on those situations that are not well explained by the basic consumer model.
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5.5
Most cab drivers rent their taxicabs for a fixed daily fee from a company. As with many services, business is highly variable from day to day. How do cabdrivers respond to these variations, many of which are largely unpredictable? A recent study analyzed actual taxicab trip records obtained from the New York Taxi and Limousine Commission for the spring of 1994. The daily fee to rent a taxi was then $76, and gasoline cost about $15 per day. Surprisingly, the researchers found that most drivers drive more hours on slow days and fewer hours on busy days.
In other words, there is a negative relationship between the effective hourly wage and the number of hours worked each day.
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5.5
A different study, also of New York City cabdrivers who rented their taxis, concluded that the traditional economic model does indeed offer important insights into drivers behavior.
The study concluded that daily income had only a small effect on a drivers decision as to when to quit for the day. Rather, the decision to stop appears to be based on the cumulative number of hours already worked that day and not on hitting a specific income target. What can account for these two seemingly contradictory results? The two studies used different techniques in analyzing and interpreting the taxicab trip records.
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Ch05 Uncertainity and Consumer Behaviour

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CHAPTER

Prepared by: Fernando & Yvonn Quijano

2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.

CHAPTER 5 OUTLINE 5.1 Describing Risk

2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.

Uncertainty and Consumer Behavior

2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.

Subjective probability is the perception that an outcome will occur.

Extent to which possible outcomes of an uncertain event

Income from Sales Jobs

Expected Income ($) Income ($)

Job 1: Commission Job 2: Fixed Salary

Difference between expected payoff and actual payoff.

2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.

Calculating Variance ($)

Outcome 1 Job 1 Job 2

Deviation Squared 250,000 100

Outcome 2 1000 510

Standard Deviation 500 99.5

Outcome Probabilities for Two Jobs

Chapter 5 Uncertainty and Consumer Behavior

Outcome 1 Job 1 Job 2 2000 1510

Outcome 2 1000 510

2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.

Chapter 5 Uncertainty and Consumer Behavior

2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.

PREFERENCES TOWARD RISK

Risk Averse, Risk Loving, and Risk Neutral

Chapter 5 Uncertainty and Consumer Behavior

2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.

PREFERENCES TOWARD RISK

Risk Averse, Risk Loving, and Risk Neutral

Chapter 5 Uncertainty and Consumer Behavior

PREFERENCES TOWARD RISK

Different Preferences Toward Risk

Chapter 5 Uncertainty and Consumer Behavior

2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.

PREFERENCES TOWARD RISK

Different Preferences Toward Risk Risk Premium

2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.

PREFERENCES TOWARD RISK

Different Preferences Toward Risk Risk Aversion and Income

Chapter 5 Uncertainty and Consumer Behavior

2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.

PREFERENCES TOWARD RISK

Different Preferences Toward Risk Risk Aversion and Indifference Curves

Chapter 5 Uncertainty and Consumer Behavior

PREFERENCES TOWARD RISK

Are business executives more risk loving than most people?

Income from Sales of Appliances ($)

Variables having a tendency to move in

The Stock Market

2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.

The Decision to Insure ($)

The Law of Large Numbers

2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.

Chapter 5 Uncertainty and Consumer Behavior

2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.

The Value of Information

Chapter 5 Uncertainty and Consumer Behavior

Profits from Sales of Suits ($)

Buying 50 suits Buying 100 suits

2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.